The Real Threat to the Iran Deal: Tehran's Banking System

The key to ensuring long-run stability of the nuclear agreement will be reintegrating Iran’s banks in the global system.

By Aaron Arnold for The Diplomat

March 22, 2016

For Iran’s president Hassan Rouhani, negotiating the nuclear agreement in exchange for sanctions relief was but one step in turning around the country’s economic woes. While a decade of financial and economic isolation has taken its toll on the country’s banking system, populist policies under former president Mahmoud Ahmadinejad, like forcing banks to provide cheap capital, have left the country undercapitalized with a high percentage of non-performing loans—as high as 20 percent, according to some estimates. Not surprisingly, foreign banks are not rushing into Iranian markets at the rate many expected, and this could spell trouble for the nuclear agreement in the long-run.

This presents a dilemma for U.S. policymakers: proceeding with the conventional wisdom and keeping Iran isolated and economically weak risks destabilizing the agreement. Although counterintuitive, moving forward with a global anti-money laundering and terrorist financing strategy that will help Iran’s banks reintegrate into the international financial system can help ensure the long-run stability of the agreement, and has the added bonus of increasing leverage over Iran should snapback sanctions be required.

According to a public opinion survey conducted by the University of Maryland’s Center for International and Security Studies (CISS), over half of Iranians believe that the nuclear agreement will bring about economic growth. While the International Monetary Fund projects a modest growth trajectory in the short and medium term, undercapitalized markets, moderate but slowing inflation, and high unemployment rates continue to plague Iran. The country’s current unemployment rate, for example, hovers around 11 percent, which is almost double that of the region, while the unemployment rate among Iran’s youth population is almost 25 percent.

Perhaps even more telling of Iran’s high expectations are the results of its parliamentary elections held this past February. Iran’s political moderates and centrists, who are mostly supporters of Rouhani, now control the Majles—Iran’s unicameral parliament. As others have pointed out, however, these are moderates who were not previously disqualified to run for election and therefore are less reformist than many hope. Nonetheless, given that Rouhani enjoys an 80 percent approval rating according to the CISS survey, but less than half the population see the economy as improving, the pressure is on to deliver his economic promises.

Although Iran has one of the more diversified economies in the region—partly a consequence of economic sanctions—crude oil still makes up almost 70 percent of the country’s exports, but only 30 percent of government revenues. With current oil prices at around $35 a barrel, and no expectations for this to change in the medium term, Rouhani will need to focus on boosting non-oil exports, which the IMF estimates are at half their current potential. The problem, however, is that Iranian financial markets lack adequate capital to ignite expected domestic growth. Thus, attracting substantial foreign investment—by most accounts—will be the key to meeting the high expectations for economic recovery.

In January, Rouhani announced an impressive goal to bring in up to $50 billion worth of foreign investment, declaring that “a stable and swift economic growth needs hefty foreign investment.” To be sure, strong foreign investment is a traditional pathway to a globally integrated economy. Since 2011, however, when sanctions against Iran began to bite, the country’s inward flows of foreign investment began a steady decline to around $2.1 billion in 2014. Growing the capital stock of foreign direct investment to $50 billion will require Rouhani to more than double Iran’s current flow of foreign investment, which The Economist estimates to be around $2.5 billion. Although ambitious, this is not a fantastical goal.

Iran: still a risky investment

While business interests in Iranian markets runs high, global banks are taking a more risk-adverse approach. For one, U.S. banks are prohibited from conducting direct transactions with Iran. This means that for Iran, U.S. dollar-denominated transactions—the preferred global currency— are still out of reach. Moreover, U.S. terrorism-related sanctions remain in effect. Foreign banks can incur penalties for knowingly facilitating transactions with designated entities, like the Iranian Revolutionary Guard. As a result, some large European and Asian banks, primarily those that have been subjected to U.S. fines in the past, have decided to avoid any transactions with Iranian individuals or companies altogether.

In February, the Financial Action Task Force (FATF), which is an international standard-setting body for anti-money laundering and terrorist financing rules and regulations, issued its first statement since the United States, European Union, and United Nations lifted sanctions against Iran. According to FATF, Iran continues to pose a serious threat to the integrity of the global financial system, and would consider asking its members to strengthen countermeasures as early as June if Iran did not take immediate actions. In addition to advising member states to guard against all transactions with Iran, FATF also recommends that members continue to apply counter-measures, such as enhanced due-diligence on transactions and systematic reporting requirements. For U.S. banks, this means increased scrutiny of foreign firms that chose to maintain business ties with Iran.

Political uncertainty in the United States is also having an effect. The 2016 presidential campaign is sidelining some investors, as frontrunner candidates have promised to “shred” the deal.

It is not just the threat of snapback sanctions keeping foreign banks at bay. According to Veliollah Seig, the governor of Iran’s Central Bank, Iranian banks are outdated. Not only have years of sanctions and financial mismanagement left Iran’s financial system in tatters, but have also left Iran’s banks behind international norms and standards.

Iran is moving in the right direction

If Rouhani is to meet his country’s high expectations for economic growth, he will need to focus efforts on reforming Iran’s financial system—including changing global perceptions about the risks of doing business with the country. In December of last year, the International Monetary Fund (IMF) released a summary of its annual bilateral consultation with Iran. While the report predicted modest economic growth for Iran in the 2016-17 year, primarily due to sanctions relief, it also cited several challenges that could constrain growth, including a continued drop in oil prices, high inflation, and weak oversight of the financial sector. Of particular importance, the IMF “urged authorities to bolster the anti-money laundering and combating terrorist financing framework to facilitate the re-integration of the domestic financial system into the global economy.” The report goes on to note that a failure to do so will likely constrain any significant foreign investment.

It seems that Iran’s leaders are taking notice. Recently, Jafar Majarrad, the former head of Iran’s central bank and current executive director for Iran at the IMF, reiterated his commitment to bolstering Iran’s anti-money laundering frameworks, as well as seeking international technical assistance. In March, Iran’s Guardian Council approved contentious Majles legislation that seeks application to the 1999 UN International Convention on the Suppression of the Financing of Terrorism. By ratifying the treaty, Iran will need to enact national legislation that criminalizes acts of terrorist financing. Of course, this is easier said than done, considering hardliner groups, like Iran’s Revolutionary Guard, have traditionally opposed similar legislation.

It also appears that Iran may be serious about joining the Eurasian Group—a FATF-style regional body that promotes the implementation of anti-money laundering and terrorist financing standards, and whose members include India, China, and Russia. While this may be a sign of a renewed commitment to banking reform, Iran has made similar overtures in the past only to eventually withdraw, citing bias and unfairness. Nonetheless, this is an opportune time for U.S. leadership to strengthen America’s commitment to global anti-money laundering and terrorist financing norms and standards. The United Kingdom, for example, has recently taken an innovative approach assisting Iranian banks—specifically Persia International Bank, Melli Bank, and Bank Sepah International—replace their outdated policies.

An opportunity for U.S. leadership

For Iran, the nuclear deal is an economic bargain—sanctions relief in exchange for giving up its nuclear enrichment capabilities. Despite widespread support for the agreement, however, nearly 82 percent of Iranians believe it is “very important” for Iran to develop its nuclear program. Thus, if Rouhani cannot bring about the expected economic growth, it could spell disaster for the longer-term prospects of the agreement. Given that Iran’s financial system is perhaps its biggest challenge to economic re-integration and recovery, and therefore a potential hurdle for the long-term stability of the nuclear agreement, the United States should take a more proactive role in strengthening global anti-money laundering and terrorist financing norms and standards.

According to a 2014 report by the Organization for Economic Co-operation and Development, global compliance with FATF money laundering standards could be better. More than 50 percent of OECD members, for example, do not take appropriate measures to ensure that their correspondent banks adhere to proper anti-money laundering and due-diligence standards. Now that Iran is re-connecting to the global correspondent banking system, this is significant because correspondent banking allows domestic banks to act on behalf of foreign banks that lack a physical presence.

What can the United States do? Increasing technical assistance, for one, can help improve global compliance with FATF standards. U.S. funding for technical assistance programs, however, seems to be on the decline. According to a recent memorandum by the House Committee on Financial Services Task Force to Investigate Terrorism Financing, the Treasury Department’s funding for technical assistance has decreased 8 percent since 2010 while the State Department’s funding has by decreased almost 24 percent. Although direct technical assistance to Iran is likely not politically feasible, correcting deficiencies in other foreign financial systems could produce the desired effect, and at the very least create pressure for Iran to continue pursuing its own reforms.

Second, the United States must continue to reassure Asian and European banks of its commitment to the spirit of the nuclear agreement, and avoid further politicization of the financial system. In the run-up to the most biting financial sanctions against Iran, U.S. officials made concerted efforts to convince global banks of the risks that Iran posed to the financial system. But, in the post-nuclear agreement world, there has been no corresponding effort to address Iran’s lack of banking standards before the country rejoins the global financial system. This sends the wrong signal, and continued politicization of the financial system could have significant consequences, such as prompting unwarranted de-risking—a phenomenon whereby banks exit a market based on a perception of risk rather than conduct proper due-diligence. In its most extreme form, de-risking could leave developing countries excluded the financial system.

Finally, the biggest challenge for the United States in maintaining long-term stability of the nuclear agreement is upending the conventional wisdom that more sanctions equals more leverage. As Ariane Tabatabai has pointed out, a globally integrated Iranian economy with a strong growth trajectory will help to ensure longer-term stability of the agreement. Thus, rather than imposing new sanctions or restricting the ability remove sanctions, Congress and the administration should focus efforts on protecting the integrity of the international financial system, which includes efforts to bring Iranian banks in line with global norms and standards.

Aaron Arnold is an associate with the Project on Managing the Atom at Harvard’s Belfer Center for Science and International Studies and an Assistant Professor at Curry College.